Chapter 15: Oligopoly and Strategic Behavior

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Chapter 15 Oligopoly and Strategic Behavior

• Overview
• All market models studied thus far have
  explicitly assumed that firms exhibit no
  strategic behavior. This chapter extends the
  theory of markets to that of oligopoly, where
  firms in the industry do exhibit strategic
  behavior. When firms are aware that the price or
  output decisions made by one firm affects the
  profits of all other firms, then they are said to
  recognize their mutual interdependence. Whenever
  a firm takes the potential reactions of other
  firms into consideration when choosing its best
  course of actions, that firm is behaving
  strategically.

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• The Fundamental Assumptions of Oligopoly
• Unique to oligopoly is mutual interdependence
  between firms and strategic behavior of firms.
• Sellers are price makers The firm-specific
  demand curve is down-sloping.
• Sellers behave strategically.
• Entry into the market may range from completely
  blocked to perfectly free.
• Buyers are price takers.

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• Appropriate Market Structure
• The size and number of buyers. There is a large
  enough number of buyers that no one individual
  can influence price.
• b. The size and number of sellers. There are few
  suppliers who behave strategically. There must
  be more than one seller, but few enough that
  mutually interdependence is felt between firms.
• c. The degree of substitutability of different
  sellers products. Firms products can range from
  perfect substitutes (basic metals) to highly
  differentiated (automobiles).
• d. The extent to which buyers are informed about
  prices and available alternatives. Oligopoly
  includes both well-informed and poorly-informed
  consumers.
• e. The conditions of entry. Entry ranges from
  free to completely blocked.

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• 15.1 Quantity-Setting Oligopolists (Cournot
  Model)
• Additional Assumptions
• There are two firms in the industry, i.e., a
  duopoly.
• Entry into the market is completely blocked.
• The firms produce homogeneous products.
• The firms have identical, constant marginal costs
  equal to c. Thus, if the output level is x, then
  total cost is cx.

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• Market Equilibrium
• A self-enforcing agreement is one which firms
  find in their best interest to abide by, given
  that other firms do the same.
• 2. A tacit agreement is a common understanding
  between firms as to how they should behave
  without discussing it.
• 3. Equilibrium is a situation in which no
  economic decision maker wants to change his or
  her action given the market outcome, and hence
  there is a tendency for the market to stay put at
  that outcome.
• 4. A firm chooses the best response when it
  chooses the best course of action, given what the
  other firms are doing.

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• A market is in equilibrium when every firm
  pursues a strategy that is a best response to the
  strategies of the other firms in the market.
  This equilibrium is called a Nash equilibrium,
  named for John Nash from the movie A Beautiful
  Mind.
• In the example, a firms strategy consists of its
  choices of output level y for Air Lion and z
  for Beta. A Nash equilibrium in quantities
  consists of two output levels, y1 and z1, such
  that
• a. Given that Beta Airlines sells z1 tickets,
  Air Lions profit is maximized by selling y1
  tickets. and
• b. Given that Air Lion sells y1 tickets, Beta
  Airlines profit is maximized by selling z1
  tickets.
• 7. A Cournot equilibrium is a Nash equilibrium in
  a market where firms strategy consists of output
  choices.

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• Finding a Cournot Equilibrium
• Deriving the Best-Response Functions
• 1. Cournot duopolists produce where MR MC.
• Find the firm-specific demand curve in panel B
  from panel A of Figure 15.2.
• a. Suppose that the price/seat is 115 and that
  Beta sells 200 seats/day.
• b. Air Lion can sell 650 seats/day without
  driving the price above 115.
• c. If Beta sells 200 seats, then Air Lion can
  sell 250 seats without driving the price above
  205.
• Air Lion has a different residual demand curve
  for each value of Betas output level. If Beta
  sells 250 seats/day rather than 200/day, then Air
  Lions residual demand curve moves to the left as
  in Figure 15.3.
• The more produced by Beta at a given price, the
  smaller the residual left for Air Lion.

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• Examine MR, MC, D curves for Air Lion using
  Figures 15.5 15.6.
• Given the number of seats supplied by Beta, there
  is a unique D and MR for Air Lion. (Figure 15.5)
• The more Beta supplies the less is left for Air
  Lion and the D and MR curves move left. (The
  profit-maximizing level of output decreases for
  Air Lion.)
• The less Beta supplies the more is left for Air
  Lion and the D and MR curves move right. (The
  profit-maximizing level of output increases for
  Air Lion.)
• Best-response curves (reaction curves) can be
  derived that show a decision makers best course
  of action for each set of choices made by other
  decision makers.
• a. Figure 15.7 shows that if Beta is selling 240
  seats/day that Air Lions best response is to
  sell 290 seats, etc.
• b. Figure 15.8 shows that if Air Lion is selling
  yq seats/day that Beta should sell zq seats/day,
  etc.

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• Use Reaction Curves to Find the Cournot
  Equilibrium using Figures 15.9 15.10.
• In equilibrium each firm must choose a best
  response to the other, so that once to the
  equilibrium point neither firms wants to move
  away from it. This means that each firm must be
  on their reaction curve.
• See in Figure 15.9 that points i, g, h have only
  one firm on its reaction curve. Point f has
  neither firm on their reaction curve. None of
  the points i, g, h, f cannot be an equilibrium.
• See in Figure 15.10 that point e1 represents a
  pair of output levels that can be supported by a
  self-enforcing agreement and is a Cournot-Nash
  equilibrium, where the two reaction curves
  intersect.

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• 15.2 Price-Setting Oligopolies
• A Bertrand equilibrium is a Nash equilibrium in a
  market in which each firms strategy consists of
  choosing a price at which to sell its output.
• Suppose there are two firms, Air Lion and Beta
  Airlines.
• The strategy consists of Air Lion choosing pA and
  Beta Airlines choosing pB.
• A Nash equilibrium in prices consists of two
  prices, p1A and p1B, such that
• Given that Beta Airlines charges p1B per ticket,
  Air Lions profit is maximized by charging p1A
  per ticket.
• Given that Air Lion charges p1A per ticket, Beta
  Airlines profit is maximized by charging p1B per
  ticket.

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• Three Cases to Consider
• Air Lion charges a higher price than Beta. (Air
  Lion sells no seats.)
• Air Lion charges a lower price than Beta. (Beta
  sells no seats.)
• Air Lion and Beta charge the same price.
  (Equilibrium will exist if the price is above
  marginal cost.)
• Figure 15.15 shows Betas firm-specific demand
  curve when Air Lion charges 130.
• a. Beta can sell no tickets above the price of
  130.
• b. Beta can sell half of the market quantity
  demanded at 130, 300 tickets.
• c. Beta can sell on the demand curve below 130.

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• Figure 15.16 shows how Beta and Air Lion can
  share the market at the price pg and with output
  Xg/2 per firm.
• Figure 15.17 shows the potential for Beta to
  undercut Air Lion on price to increase profits.
• Bertrand Equilibrium
• If price is set equal to marginal cost, then it
  would not be cut by either firm, for that would
  drive profits negative.
• Each firm setting price equal to marginal cost is
  a self-enforcing agreement.
• Conclusion When all firms have costs that are
  constant at c, the Bertrand equilibrium requires
  that firms set their price to c.

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• Cournot or Bertrand Which model is best?
• The Cournot model is appropriate when firms make
  fixed production plans, i.e., changing price is
  easier than changing production. (Examples
  supermarkets, gas stations, discount stores)
• The Bertrand model is appropriate when firms have
  committed to prices rather than to quantities,
  e.g., mail-order catalog stores.

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• 15.3 Cooperation and Punishment
• The costs and benefits of cheating are explained
  in Figure 15.19, where benefits are A, costs B
  and T is the time to detect the cheating.
• General Predictions With few of firms comes the
  potential for collusion.
• The longer it takes to catch a cheater, the
  greater the incentive to cheat.
• The less likely it is that a cheater will be
  caught, the greater the incentive to cheat.
• The harsher the punishment that a cheater faces,
  the lower the incentive to cheat on an agreement.
• The more complex the collusive agreement has to
  be, the less likely it is to succeed.

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• Market Structure and Collusion
• The more that the firms costs differ, the less
  likely is cooperation, ceteris paribus.
• The more that demand varies from period to
  period, the less likely is cooperation, ceteris
  paribus.
• The easier it is for firms to monitor their
  rivals output levels, the more likely is
  cooperation, ceteris paribus.
• Product differentiation may increase or decrease
  the likelihood of cooperation, ceteris paribus.
• When prices are negotiated with each customer
  separately, collusion is less likely to be
  successful, ceteris paribus.
• When individual orders are large relative to the
  overall market, collusion is less likely to be
  successful, ceteris paribus.
• The more firms in a market, the less likely is
  cooperation, ceteris paribus.

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Chapter 15 Discussion Questions

• Work the following problems on pages 518-519
  15.2, 15.4, 15.8.